The rupee, Asia’s worst-performing currency this year, touched a record low on Thursday with rising oil prices threatening to stoke inflation and worsen government finances.

Liquidity in the financial system is currently at a deficit of around Rs 215.7 billion ($3.14 billion), according to the Bloomberg Economics India Banking Liquidity Index.(Dhiraj Singh/Bloomberg)

RBI’s efforts to tighten the availability of rupees in the market and halt a slide in the currency may squeeze profitability at the nation’s lenders as it raises their funding costs, according to the local unit of Moody’s Investors Service.

The rupee, Asia’s worst-performing currency this year, touched a record low on Thursday with rising oil prices threatening to stoke inflation and worsen government finances. State-run banks probably sold dollars on behalf of the Reserve Bank of India to arrest these declines, local traders said. Creating a shortage of the local currency risks worsening liquidity in India’s banking system, which is already running short of cash.

“Liquidity is already tight in the system and any efforts by RBI to strengthen the local currency will suck that out and squeeze banks further,” said Karthik Srinivasan, group head of financial sector ratings at ICRA Ltd., the local unit of Moody’s. “A profit pinch will be felt and lenders with a higher portion of funding coming from bulk deposits and debt will be affected the most.”

Domestic lenders can hardly afford another headwind as they absorb trading losses from the past year’s drop in sovereign bonds and continue to battle one of the world’s worst bad-loan ratios. The country’s largest banks including State Bank of India and ICICI Bank Ltd. raised lending rates earlier this month given a combination of weak deposit growth and the strongest loan demand in four years.

Liquidity in the financial system is currently at a deficit of around Rs 215.7 billion ($3.14 billion), according to the Bloomberg Economics India Banking Liquidity Index, having moved from a surplus of Rs 5.5 trillion in March 2017. Advance tax outflows in the second half of June sparked the cash crunch.

Banks that have large investments in corporate bonds will see a further erosion in profits if yields surge following measures by the RBI to curtail currency volatility, according to ICRA.

Breathing space

The average yield on top-rated 10-year corporate notes issued by state-run companies has already climbed 77 basis points this year to 8.61 percent on Thursday, according to data compiled by Bloomberg. The rate had soared to 8.80 percent on June 7, the highest since October 2014.

In 2013, when the rupee depreciated 18 percent in four months, the RBI raised interest rates, capped its daily fund infusions and moved to drain money from the economy through bond sales. It raised its benchmark rate for the first time since 2014 this month, joining central banks in Indonesia and the Philippines, which tightened monetary policy to defend their currencies. The central bank maintains it doesn’t protect any rupee level but intervenes only to smooth volatility. The RBI declined to comment.

One way for the central bank to prevent an immediate liquidity impact from its foreign-exchange operations is by intervening in the onshore forwards or currency futures market, thus pushing the impact on rupee liquidity to a future date. The RBI has been increasingly using these for its forex interventions.

As most banks have excess capital reserve buffers, “breathing space of about a month will be available,” Srinivasan said. “We haven’t changed credit outlook of any lenders based on this so far.”